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The Magic Formula for Building Products

This mechanical strategy could be magic.

If you're a busy investor with more than just stock-picking on your plate, you might want to consider a mechanical investing strategy. And if you're interested in stocks, one of the most intriguing of these strategies is Joel Greenblatt's Magic Formula.

Greenblatt details this approach in his enriching, funny The Little Book That Beats the Market. His strategy revolves around two factors:

How cheap is the stock?

How profitable is the company?

This simplified approach really boils down value investing to its essence. When you find a company whose price fails to reflect its high profits, you might have a winner.

A cheap business and a profitable companyTo find cheap companies, the Magic Formula looks for a high earnings yield -- basically, a company's EBIT divided by its enterprise value. EBIT is earnings before interest and taxes, otherwise known as operating earnings. Enterprise value includes the company's market capitalization and then adds its net debt. In general, the higher the earnings yield, the better. The Magic Formula looks for a yield higher than 10%.

To find profitable companies, Greenblatt's Magic Formula seeks businesses that generate pre-tax returns on assets (ROA) greater than 25%. In other words, for every $100 in assets it holds, the company would produce at least $25 in net profit. In general, the higher the ROA, the better the business. Greenblatt looks for companies with an ROA higher than 25%.

So how do some of the biggest companies in building products fare?

Company

Enterprise Value

EBIT

Earnings Yield

ROA

USG(NYSE: USG)

$2,987

($124)

(4.2%)

(3.2%)

Lennox International(NYSE: LII)

$2,277

$184

8.1%

10%

Ameresco(NYSE: AMRC)

$918

$51

5.5%

6.4%

Universal Forest Products(Nasdaq: UFPI)

$659

$15

2.2%

1.8%

Simpson Manufacturing(NYSE: SSD)

$1,390

$74

5.3%

8.6%

Owens Corning

$5,824

$411

7.1%

5.4%

Masco

$6,769

$137

2%

1.7%

Fortune Brands Home & Security

$2,649

$160

6%

4.2%

Armstrong World Industries

$3,175

$220

6.9%

7.1%

AO Smith

$1,744

$126

7.2%

5.3%

Source: S&P Capital IQ.

Going by the Magic Formula criteria, none of these companies meets either standard, and USG throws out negative numbers in both categories. Lennox International has the highest ROA at 10%, which is still less than half of the formula's desired 25%. Lennox also has the highest earnings yield at 7.2%, which is still below the formula's desired 10% yield. So it looks like the companies in this sector are still too expensive to be bought mechanically.

USG constructs both residential and commercial buildings as well as being involved in repairing roads and making ceramics. USG's margins have suffered a great deal from the construction slowdown that has occurred since the beginning of the recession, which has hit USG extra hard because of its significant exposure to the struggling residential market. The company also has a high debt load.

Lennox, which manufactures heating and cooling appliances, has also suffered from the economic downturn. Increased commodity and freight costs have been eating into the company's profits.

Ameresco specializes in energy-efficient building solutions and finds creative ways to reduce risk for its customers by offering them turnkey products and performance contracts. California's new incentives for renewable and clean energy may also help the company grow.

Universal Forest Products, which manufactures lumber and wood products, announced massive layoffs to cut costs last June. While this is an understandable response to the struggles it faces in tough economic times, the sacrifice of experienced employees and eventual replacement with cheaper but less experienced workers may put the company in a weaker competitive position in the long term.

Simpson Manufacturing stands out in this group by offering a dividend, even if it is only 1.5%. Its shares have also done reasonably well given the current economic climate, with an increase in its share price of almost 10% from last year.

Foolish bottom lineThe key advantage of the Magic Formula is speedy decision-making. You can run a screen, mechanically buy the stocks, and then spend your free time doing the activities you love. However, such an approach means that you need to pick a lot of stocks (say, 25 or 30), since you haven't performed any strategic analysis of your investments. According to the formula, you should hold the stocks for one year to receive favorable tax treatment, sell all of them, and then run the screen again to find your new picks.

While this approach sounds easy, Greenblatt cautions that it can be tough to stick with during hard times. In some years, this mechanical strategy simply won't work. However, Greenblatt's extensive backtesting suggests that over the long haul, his Magic Formula can significantly outperform the market.